The Debt Service Coverage Ratio helps loan providers determine whether to approve a loan application. Business Loan providers usually use this parameter to evaluate an individual or company’s loan eligibility. So, assessing an applicant's financial health and creditworthiness is a useful metric, especially when they apply for additional debt.
The following sections will discuss the DSCR meaning, calculation formula, pros and cons, examples, mistakes to avoid, etc.
What is the Debt-Service Coverage Ratio (DSCR)?
The DSCR ratio measures a company’s cash flow availability and compares it to its debt. Essentially, it measures whether a business entity can repay its debt conveniently. A company can utilize the ratio for both short and long-term loans, as it includes both the interest and principal components of loans, lines of credit, and bonds.
DSCR is a key component in determining the maximum loan amount a company may borrow. It shows lenders whether a company has sufficient cash flow to repay its loans.
Debt Service Coverage Ratio Formula
The Debt Service Coverage Ratio formula has two major components: the total debt the company is servicing and its net operating income. Net operating income is a business’s revenue after subtracting its operational expenses, excluding interest and tax payments. Usually, it is equal to the earnings before EBIT (Earnings Before Interest and Taxes).
DSCR = Net Operating Income divided by Total Debt Service
Here, Net Operating Income = Revenue − COE
COE = Certain operating expenses
Total Debt Service = Current debt obligations
Total debt service is equal to a company’s current debt obligations, including interest, principal, lease payments, and sinking fund due in the next year. It includes the current portion of short and long-term debt on the balance sheet.
Also Read: 5 C's Of Credit - Guide To What Lenders Look In A Loan Application
How to Calculate Debt Service Coverage Ratio (DSCR) in Excel?
Rather than manual DSCR calculation, an individual can also calculate the DSCR ratio in Excel. It makes the work much easier and faster while eliminating any chances of errors. Follow these steps to calculate DSCR in Excel:
- Row 1: Give a title to the sheet
- Row 2: Write headings, including the company name and the financial data. Locate headings and label them as follows:
- A2 = Company Name
- B2 = Net Operating Income
- C2 = Total Debt Service
- D2 = DSCR
- A3, A4, etc., will be the company name locations.
- Row 3: Write the data of Company A into the spreadsheet
- Place your cursor in cell D3.
- Write the DSCR formula beginning with an equal sign. It should be =B3/C3.
- Press Enter
Excel will automatically highlight the cells in the formula calculation while typing. Press Enter to complete the calculation and show the results.
Also Read: A Quick Guide To Finding The Right Loan For Your Business
Advantages and Disadvantages of Debt Service Coverage Ratio (DSCR)
Let's look at the advantages and disadvantages of Debt Service Coverage Ratio when submitting a Business Loan application:
| Advantages | Disadvantages |
| Helps compare operational efficiency across a company | Heavily relies on accounting guidance that may not align with the company’s urgent financial requirements |
| Helpful in strategic planning and budgeting, as a declining DSCR ratio may indicate a decline in the business’s finances | More complex than other financial ratios |
| DSCR calculations from competitors help a company analyse its performance and efficiency | Does not incorporate all finances fully, such as taxes |
| Gives a comprehensive overview of a business’s financial well-being | Lack of consistency, as the treatment varies between Business Loan providers |
| Often calculated on a rolling annual basis | |
| Calculating DSCR over a period of time helps understand a company's financial status and trends. | |
| Includes a bigger number of financial categories than other ratios | |
Also Read: Different Types Of Business Loans For Women Entrepreneurs
Interest Coverage Ratio vs. Debt Service Coverage Ratio (DSCR)
Apart from the Debt Service Coverage Ratio, the Interest Coverage Ratio is another common term Business Loan applicants usually come across. Here is an overview of the differences between them:
| Parameter | Interest Coverage Ratio | Debt Service Coverage Ratio |
| Meaning | Indicates how many times a company has earned profit before paying taxes and interest | Indicates a company’s ability to earn enough profit to cover its financial obligations, including principal, interest, etc. |
| Calculation Formula | ICR = EBT divided by Interest | DSCR = Net Operating Income divided by Total Debt Service |
| Range | 1.5 to 2 | 1.25 to 1.5 |
| What it Does Not Cover | Principal payments | Changes in working capital requirements |
| Application | Debt restructuring, investments, lending decisions | Debt restructuring, investments, lending decisions, performance measurement |
Also Read: Credit Score Is Not The Only Factor To Focus On When Applying For A Business Loan
Example of Debt Service Coverage Ratio (DSCR)
Let’s understand the working of DSCR calculation with an example:
A company needs a Business Loan to expand its business operations and wants to calculate its DSCR ratio. The accounting team must calculate the company’s net operating income to calculate the DSCR.
Net operating income = Gross profit – Operating expenses
If its gross profit is Rs. 25 million and its operating expenses are worth Rs. 20 million, its net operating income using the given formula will be Rs. 5 million. Now, they must calculate the total debt service.
Total debt service = Interest payment + Principal payments
If its principal loan payment is Rs. 5 million and interest expense is Rs. 0.5 million, its total debt service will be Rs. 5.5 million. Using the net operating income and total debt service, they can now calculate the DSCR ratio using this formula:
DSCR = Net Operating Income / Total Debt Service
DSCR = Rs. 5 million / Rs. 5.5 million
DSCR = Rs. 0.91 million
Since the company has a DSCR of 0.92, it is below 1. It indicates that the company lacks cash flow to repay its debt. That means the company owners must use their personal funds to make their debt repayments. The lending company may feel sceptical about approving their Business Loan application in such a scenario.
Also Read: Get An Instant Business Loan. Find Out How?
What are the 3 Mistakes to Avoid When Calculating the Debt Service Coverage Ratio (DSCR)?
DSCR calculation is a straightforward process that involves minor formula applications. However, here are a few mistakes to avoid:
1. Calculating the Wrong Principal
Balance sheets only show outstanding balances on loans rather than the actual principal payments. Therefore, some form of internal record-keeping is essential to calculate principal during an accounting period. Some users may also get confused if the company borrows a new loan during a year. In such a situation, they should avoid accumulating together various loans to simplify the calculation. Choosing a different repayment schedule for each loan is a good strategy for estimating this amount and making a correct calculation.
2. Incorrect Capital Lease Expenses
Capital lease expenses are another source of confusion when calculating DSCR. It is a long-term asset lease often considered an asset purchase. For instance, if a construction company rents a forklift for three years, it may purchase the equipment at the lease end at a fair price. Some Business Loan providers exclude lease payments from the DSCR, while others may include them, leading to confusion.
3. Inaccurate EBITDA vs EBIT
EBIT is Earnings Before Interest and Taxes, while EBITDA is Net Profit + Interest + Taxes + Depreciation And Amortisation. Many people get confused between the two when calculating the DSCR. Another reason for confusion is that EBITDA does not appear on the income statements, which means they must calculate it separately.
Also Read: Different Types Of Financial Ratios In Business And Their Significance
Conclusion
When planning to apply for a Business Loan, understanding DSCR meaning and calculation method is an effective exercise. If it is not in its best condition, there are ways to improve it. The key is to focus more on driving revenue and reducing expenses and debt.
You can apply for a Business Loan of up to Rs 40 Lakh at a competitive interest rate and flexible repayment tenure from Hero FinCorp online.
Frequently Asked Questions
1. What Is a Good DSCR?
A DSCR between 1.25 and 1.5 is an acceptable range.
2. Why is the DSCR Important?
DSCR indicates a company’s ability to cover its financial obligations, including principal, interest, etc.
3. What is Interpreting the DSCR Ideal Ratio?
Interpreting the DSCR ideal ratio means calculating the DSCR to determine a company’s ability to cover its obligations. A DSCR between 1.25 and 1.5 is good enough to attract a new loan approval.
4. What is the use of the debt service coverage ratio?
DSCR is used in debt restructuring, investments, lending decisions, and performance measurement.
